Why Do Distressed Firms Acquire?

Acquisitions made by distressed firms in recent years are economically important. This paper explores the rationale behind such acquisitions using a natural experiment. Exploiting a recent tax change which reduces debt restructuring costs for certain creditors and decreases bankruptcy risk, I identify the causal link between financial distress and acquisitions. Upon an exogenous reduction in the probability of bankruptcy, distressed firms react by cutting 34% of cash spending on acquisitions. Moreover, distressed firms refocus by decreasing 75% of the transaction value of diversifying acquisitions and doubling divestitures. The evidence supports the financial synergy hypothesis that distressed firms acquire to diversify cash flow risk, rather than the growth opportunity hypothesis that distressed firms acquire to capture external growth opportunities and revive growth. These findings indicate a new effect of financial distress on investment decisions. When firms are under pressure to meet debt obligations, it creates an incentive for firms to diversify via acquisitions.